Valuation: Closing Thoughts

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Valuation Closing Thoughts

• Fall 2014
• It aint over till its over

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Back to the very beginningApproaches to
Valuation

• Discounted cashflow valuation, where we try
  (sometimes desperately) to estimate the intrinsic
  value of an asset by using a mix of theory,
  guesswork and prayer.
• Relative valuation, where we pick a group of
  assets, attach the name comparable to them and
  tell a story.
• Contingent claim valuation, where we take the
  valuation that we did in the DCF valuation and
  divvy it up between the potential thieves
  (equity) and the victims of this crime (lenders)

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Intrinsic Valuation The set up
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Dante meets DCF Nine layers of valuation hell..
And a bonus layer..
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Layer 1 Base Year fixation.

• You are valuing Exxon Mobil, using the financial
  statements of the firm from 2008. The following
  provides the key numbers
• Revenues 477 billion
• EBIT (1-t) 58 billion
• Net Cap Ex 3 billion
• Chg WC 1 billion
• FCFF 54 billion
• The cost of capital for the firm is 8 and you
  use a very conservative stable growth rate of 2
  to value the firm. The market cap for the firm is
  373 billion and it has 10 billion in debt
  outstanding.
• a. How under or over valued is the equity in the
  firm?
• b. Would you buy the stock based on this
  valuation? Why or why not?

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Layer 2 Taxes and Value

• Assume that you have been asked to value a
  company and have been provided with the most
  recent years financial statements
• EBITDA 140
• - DA 40
• EBIT 100
• Interest exp 20
• Taxable income 80
• Taxes 32
• Net Income 48
• Assume also that cash flows will be constant and
  that there is no growth in perpetuity. What is
  the free cash flow to the firm?
• 88 million (Net income Depreciation)
• 108 million (EBIT taxes Depreciation)
• 100 million (EBIT (1-tax rate) Depreciation)
• 60 million (EBIT (1- tax rate))
• 48 million (Net Income)
• 68 million (EBIT Taxes)

• Free Cash flow to firm
• EBIT (1- tax rate)
• (Cap Ex Depreciation)
• - Change in non-cash WC
• FCFF

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Layer 3 High Growth for how long

• Assume that you are valuing a young, high growth
  firm with great potential, just after its initial
  public offering. How long would you set your high
  growth period?
• lt 5 years
• 5 years
• 10 years
• gt10 years

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Layer 4 The Cost of Capital

• The cost of capital for Chippewa Technologies, a
  US technology firm with 20 of its revenues from
  Brazil, has been computed using the following
  inputs

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The Correct Cost of Capital for Chippewa
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Layer 5 The price of growth..

• You are looking at the projected cash flows
  provided by the management of the firm, for use
  in valuation
• What questions would you raise about the
  forecasts?

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Layer 6 The fixed debt ratio assumption

• You have been asked to value Hormel Foods, a firm
  which currently has the following cost of
  capital
• Cost of capital 7.31 (.9) 2.36 (.1) 6.8
• You believe that the target debt ratio for this
  firm should be 30. What will the cost of capital
  be at the target debt ratio?
• Which debt ratio (and cost of capital) should you
  use in valuing this company?

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Layer 7 The Terminal Value

• The best way to compute terminal value is to
• Use a stable growth model and assume cash flows
  grow at a fixed rate forever
• Use a multiple of EBITDA or revenues in the
  terminal year
• Use the estimated liquidation value of the assets
• You have been asked to value a business. The
  business expects to 120 million in after-tax
  earnings (and cash flow) next year and to
  continue generating these earnings in perpetuity.
  The firm is all equity funded and the cost of
  equity is 10 the riskfree rate is 3 and the
  ERP is 7. What is the value of the business?
• Assume now that you were told that the firm can
  grow earnings at 2 a year forever. Estimate the
  value of the business.

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Layer 8. From firm value to equity value The
Garnishing Effect

• For a firm with consolidated financial
  statements, you have discounted free cashflows to
  the firm at the cost of capital to arrive at a
  firm value of 100 million. The firm has
• A cash balance of 15 million
• Debt outstanding of 20 million
• A 5 holding in another company the book value
  of this holding is 5 million. (Market value of
  equity in this company is 200 million)
• Minority interests of 10 million on the balance
  sheet
• What is the value of equity in this firm?
• How would your answer change if you knew that the
  firm was the target of a lawsuit it is likely to
  win but where the potential payout could be 100
  million if it loses?

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Layer 9. From equity value to equity value per
share

• You have valued the equity in a firm at 200
  million. Estimate the value of equity per share
  if there are 10 million shares outstanding..
• How would your answer change if you were told
  that there are 2 million employee options
  outstanding, with a strike price of 20 a share
  and 5 years left to expiration?

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Layer 10. The final circle of hell
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Your numbers/findings

• The truth shall set you free.

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The Models You Used in DCF Valuation
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What you found
under or over value
Average 14.26
Median -2.01
Low -45.87
High 497.82
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The most undervalued stocks
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The Most Overvalued stocks are...
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The ultimate test Did undervalued stocks make
money?
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More on the winners...

• About 60 of all buy recommendations make money
  about 45 of sell recommendations beat the
  market. The average return on buy recommendations
  was about 4 higher, on an annualized basis, than
  the average return on sell recommendations.
• The excess returns on buy recommendations on
  small cap and emerging market companies is higher
  than the excess returns on large market cap
  companies, with higher mistakes in both
  directions on the former.
• There are two or three big winners in each
  period, but the payoff was not always immediate.
  Buying Apple in 1999 would have led to negative
  returns for a year or more, before the turnaround
  occurred.
• Stocks that are under valued on both a DCF and
  relative valuation basis do better than stocks
  that are under valued on only one approach.

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Relative Valuation The Four Steps to
Understanding Multiples

• Anna Kournikova knows PE. Or does she?
• In use, the same multiple can be defined in
  different ways by different users. When comparing
  and using multiples, estimated by someone else,
  it is critical that we understand how the
  multiples have been estimated
• 8 times EBITDA is not always cheap
• Too many people who use a multiple have no idea
  what its cross sectional distribution is. If you
  do not know what the cross sectional distribution
  of a multiple is, it is difficult to look at a
  number and pass judgment on whether it is too
  high or low.
• You cannot get away without making assumptions
• It is critical that we understand the
  fundamentals that drive each multiple, and the
  nature of the relationship between the multiple
  and each variable.
• There are no perfect comparables
• Defining the comparable universe and controlling
  for differences is far more difficult in practice
  than it is in theory.

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(No Transcript)
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The Multiples you used were ...
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DCF vs Relative Valuation
under or over value
Average 106.52
Median 102.16
Low 0.E0
High 324.57
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Most undervalued on a relative basis
Company Name Price Relative Value under valued Recommendation
RadioShack 1.47 4.422 -66.76 Buy
Samsung Electronics 1,346,000.00 3,921,212.00 -65.67 Buy
Chesapeake Energy 26.59 77.26 -65.58 Buy
Lululemon Athletica inc. (LULU) 43.77 126.79 -65.48 Buy
Commerzbank AG 11.70 29.76 -60.69 Buy
Commerzbank AG 11.70 29.76 -60.69 Buy
Tesla Motor Inc. 182.26 369.76 -50.71 Sell
Pandora 22.62 41.71 -45.77 Buy
Wynn Resorts, Limited (WYNN) 200.49 354.84 -43.50 Buy
Clear Channel Outdoor Holdings (NYSE CCO) 8.14 12.99 -37.34 Buy
Tata Motors Limited (BSE500570) 427.5 645.93 -33.82 Buy
Garuda Indonesia IDR456 IDR649 -29.74 Buy
Lululemon (LULU) 43.77 61.98 -29.38 Buy
Kohl's Corporation 54.75 76.95 -28.85 Buy
Incyte 52.08 71.05 -26.70 Buy
Criteo 26.89 36.05 -25.41 Buy
Quest Diagnostics, Inc. (DGX) 57.18 72.58 -21.22 Buy
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Most overvalued on a relative basis
Company Name Price Relative Value under valued Recommendation
J.C.Penny 8.80 0.26 3284.62 Sell
ARM Holdings plc (ARM) 26.63 8.47 214.40 Sell
Aerovironment 32.29 10.38 211.08 Sell
GrubHub 31.18 10.16 206.89 Sell
Amazon (AMZN) 292.24 108.93 168.28 Sell
Yelp 52.13 20.29 156.92 Sell
Dynegy (DYN) 31.89 13.52 135.87 Sell
Netflix Inc. 328.55 153.06 114.65 Sell
3D Systems (NYSE DDD) 47.64 23.93 99.08 Sell
Tesla Motors 179.00 106.00 68.87 Sell
Moncler 12.45 7.54 65.12 Sell
BHP Billiton 69.51 42.55 63.36 Sell
Fortinet Inc. 20.36 13.00 56.62 Sell
Ocado Group 3.18 2.04 55.88 Sell
J. C. Penney Company, Inc. (NYSEJCP) 8.86 5.93 49.41 Sell
Rosetta Stone 11.47 7.89 45.37 Sell
Keurig Green Mountain, Inc. (NASDAQGMCR) 108.47 75.35 43.95 Sell
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Contingent Claim (Option) Valuation

• Options have several features
• They derive their value from an underlying asset,
  which has value
• The payoff on a call (put) option occurs only if
  the value of the underlying asset is greater
  (lesser) than an exercise price that is specified
  at the time the option is created. If this
  contingency does not occur, the option is
  worthless.
• They have a fixed life
• Any security that shares these features can be
  valued as an option.
• Number of firms valued using option models 8
• Median Percent increase in value over DCF value
  55

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Value Enhancement You too can do it!
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Alternative Approaches to Value Enhancement

• Maximize a variable that is correlated with the
  value of the firm. There are several choices for
  such a variable. It could be
• an accounting variable, such as earnings or
  return on investment
• a marketing variable, such as market share
• a cash flow variable, such as cash flow return on
  investment (CFROI)
• a risk-adjusted cash flow variable, such as
  Economic Value Added (EVA)
• The advantages of using these variables are that
  they
• Are often simpler and easier to use than DCF
  value.
• The disadvantage is that the
• Simplicity comes at a cost these variables are
  not perfectly correlated with DCF value.

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The bottom line

• Old wine in a new bottle All discounted cash
  flow models (cost of capital, APV, EVA, Excess
  return models) are all variants of the same model
  and, done right, should yield the same value.
• No magic bullets Value enhancement is hard work.
  There are no short cuts and adopting EVA, CFROI
  or any other measure will not increase value.
• Tying compensation systems to a measure is a
  recipe for game playing If you tie management
  compensation to EVA, for instance, can lead to
• The Growth trade off game Managers may give up
  valuable growth opportunities in the future to
  deliver higher EVA in the current year.
• The Risk game Managers may be able to deliver a
  higher dollar EVA but in riskier businesses. The
  value of the business is the present value of EVA
  over time and the risk effect may dominate the
  increased EVA.
• The capital invested game The key to delivering
  positive EVA is to make investments that do not
  show up as part of capital invested. That way,
  your operating income will increase while capital
  invested will decrease.

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Acting on valuation It is not just an academic
exercise

1. I am not sure yet Uncertainty is not a shield
   against action. If you wait until you feel
   certain about your valuation, you will never
   act.
2. All believers now? Ultimately, you have to
   believe in some modicum of market efficiency.
   Markets have to correct their mistakes for your
   valuations to pay off.
3. The law of large numbers Assuming your
   valuations carry heft, you are far more likely to
   be right across many companies than on any
   individual one.

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Your recommendations were to..
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ChoicesChoicesChoices
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Picking your approach

• Asset characteristics
• Marketability
• Cash flow generating capacity
• Uniqueness
• Your characteristics
• Time horizon
• Reasons for doing the valuation
• Beliefs about markets

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What approach would work for you?

• As an investor, given your investment philosophy,
  time horizon and beliefs about markets (that you
  will be investing in), which of the the
  approaches to valuation would you choose?
• Discounted Cash Flow Valuation
• Relative Valuation
• Neither. I believe that markets are efficient.

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Some Not Very Profound Advice

• Its all in the fundamentals. The more things
  change, the more they stay the same.
• Focus on the big picture. Dont sweat the small
  stuff and dont get distracted.
• Anecdotes mean little and experience does not
  equal knowledge.
• Keep your perspective. It is only a valuation.
• In investing, luck dominates skill and knowledge.